Universtity of Groningen Faculty of Management and Organisation Master Thesis
Eldar Hasic 1 Deloitte & Touche Corporate Finance
Eldar Hasic 2 Deloitte & Touche Corporate Finance
Eldar Hasic 3 Deloitte & Touche Corporate Finance
Preface
In the past six months I have analysed the market risk premium in the Netherlands for Deloitte & Touche Corporate Finance. It has been an interesting period where many opinions on the subject have been discussed with the valuation experts. Also professional opinions from the university mentors Dr. Henk von Eije and Dr. Derk Jan Kiewit have provided useful and improved insights in the subject.
First of all I would like to thank my parents and family for their indispensable support and patience during my internship at Deloitte & Touche Corporate Finance and the overall university education program.
Furthermore I would like to pay my gratitude to Mr. Maarten Vijverberg for the internship possibility at Deloitte & Touche Corporate Finance. In the six months internship Gonneke van der Lee and Jeroen van der Wal were patient, friendly and helpful in providing
essential feedbacks on the subject and in general.
The essentials behind the subject are important issues and people at Deloitte & Touche Corporate Finance have encouraged me to pursue related issues in a very pleasant and appealing working environment, where many fruitful discussions have been held.
A special gratitude is for my university mentors. Dr. von Eije and Dr. Kiewit who have provided me with significant and vital information, which has enabled me to better understand and interpret the problem situation.
In the final comments I would to thank persons that are not mentioned so far. With many internal and external discussions they have contributed a great deal to my understanding of the problem situation.
The quest on the market risk premium subject goes on. Academics described in this paper tell us that a better understanding on the subject is only possible when different opinions and perspectives are considered. This encourages and enables us to think and solve complex problem situations such as the market risk premium.
Eldar Hasic
Amsterdam,
15 July 2003
Eldar Hasic 4 Deloitte & Touche Corporate Finance
Table of Contents
Introduction and Overview 6
§ 1.1 Market Risk Premium Introduction 6
§ 1.2 Research Introduction 6
§ 1.3 Deloitte & Touche Introduction 7
§ 1.3.1 DTT in the Netherlands 8
§ 1.3.2 DTCF in the Netherlands 8
§ 1.4 Research Methodology 8
§ 1.4.1 Research Background 9
§ 1.4.2 Research Question and Preliminary Conceptual Framework 10
§ 1.4.3 Research Overview 13
Chapter 2 External Analysis DTCF 15
§ 2.1 Environmental Shifts 15
§ 2.1.1 Globalisation and Growth 16
§ 2.1.2 Labour Mobility 17
§ 2.1.3 Market Sophistication 19
§ 2.1.4 Information & Information Technology 20
§ 2.1.5 Agency Costs & Concentration 21
§ 2.1.6 Government Regulation and Policy 22
§ 2.2 Business Cycles and Economical Outlook 24
§ 2.2.1 Business Cycle Expectation 24
§ 2.2.2 Environmental Outlook 25
§ 2.3 Conclusion (confidential) 26
Chapter 3 Internal Analysis of DTCF 27
§ 3.1 Strategic Choices at DTCF 27
§ 3.1.1 Strategy Process at DTCF 28
§ 3.1.2 Strategy Content at DTCF 29
§ 3.1.3 Strategy Context at DTCF 29
§ 3.2 Interpretation, Processing and Application 29
§ 3.2.1 Formalisation at DTCF 30
§ 3.2.2 Standardisation at DTCF Valuation Group (confidential) 30
§ 3.2.3 Communication and Information at DTCF Valuation Group 30
§ 3.3 Conclusion (confidential) 32
Chapter 4 Literature Overview 33
§ 4.1 Capital Asset Pricing Model (CAPM) 33
§ 4.1.1 CAPM Development 34
§ 4.1.2 Beta (β) 36
§ 4.1.3 MRP Specification 38
§ 4.1.3.1 MRP Measuring Period 38
§ 4.1.3.2 MRP Measuring Method 43
§ 4.1.3.3 MRP Measuring Definition 46
§ 4.2 Dividend, Earnings and Corporate Productivity Model 48
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§ 4.2.1 Forward-Looking Dividend and Earnings Model 51
§ 4.2.2 Differences in Forward-Looking Models 52
§ 4.3 Demand Side Model and Professionals Surveys 52 Chapter 5 Transparent MRP Choice at DTCF 54
§ 5.1 Transparent MRP at DTCF 54
§ 5.1.1 Equity in the Netherlands 55
§ 5.1.2 Risk Free Rate in the Netherlands 55
§ 5.1.3 Transparent MRP Calculation at DTCF 55
§ 5.2 Transparent MRP Calculating Outcome at DTCF 57 Chapter 6 Conclusion and Learning Implications 59
§ 6.1 Conclusion 59
§ 6.2 Equity Risk Premium a Puzzle? 61
Literature 64
Appendix # 69
Eldar Hasic 6 Deloitte & Touche Corporate Finance
Introduction and Overview
§ 1.1 Market Risk Premium Introduction
Various articles analyse the market risk premium (mrp). Deloitte & Touche Corporate Finance B.V. (DTCF) in the Netherlands initiates additional research on the mrp. DTCF performs business valuations with a long-term perspective. Paragraph 1.2 introduces shortly the motive behind the conducted research. In paragraph 1.3, the introduction of the Deloitte & Touche organisation will follow. Finally, paragraph 1.4 provides deeper insight to the research background and the research methodology.
§ 1.2 Research Introduction
DTCF provides advisory services organised around selling, valuation, acquisition, and financing of various businesses in the Netherlands. The organisation provides the advisory services by the means of strategic financial, legal, and fiscal knowledge.
In order to provide sound financial analysis, the discounted cash flow method (dcfm) is the primary financial valuating instrument. In the dcfm, the value of any asset is the present value of future cash flows to and from the owner of that asset (see chapter 4).
First element of the dcfm is the projected cash flow estimate, which is discussed in-depth with the client. Here DTCF has developed standard theoretical and practical guidelines for the cash flow estimation process (see chapter 3).
However, the discussion continues for the second element of the dcfm, which is the cost of capital. The cost of capital consists of two components. These are the costs of equity capital and the cost of debt. Together they are captured in the weighted average cost of capital equation (wacc) (see chapter 4).
For the equity costs estimation it is possible to use various models. At DTCF, preferred equity cost-estimating model is the capital asset pricing model (capm). The capm is widely used within the financial sector as an initial valuation methodology. The last element of the capm is the mrp. The mrp is the difference between the market portfolio return and the risk free asset. When measured over a sufficiently long period, the difference between these two returns is called the mrp or the equity risk premium (see paragraph 1.4 and chapter 4).
The competitive, dynamical and demanding environment in the Netherlands force many
financial companies to rethink and to reinforce operational activities. The challenge of this
research and for DTCF is the interpretation of the data and the ability to apply it to the
current and future business developments. Additional exploration of alternative models is
needed in order to provide transparent alternatives.
Eldar Hasic 7 Deloitte & Touche Corporate Finance
A broad technical and economically business embedded analysis is required in order to be able to seek for the best possible transparent valuation solution related with the mrp puzzle (see sub-paragraph 1.3.3 and chapter 4).
DTCF requires a transparent mrp solution for the mrp puzzle, which must be integrated within their business valuation policy of going-concern companies. The DTCF continuous quality management program drives the internal need for the business valuation policy standard in form of the best possible solutions. The recent integration with Andersen Corporate Finance in the Netherlands provides an additional organisational challenge for DTCF to cope with the external and internal developments (see chapters 2, 3, and 4).
The primary goal of DTCF is to provide academically and practically sound services to the clients in the Netherlands. Currently, the quality management program has provided some answers to the external and internal developments. For DTCF, desired
reinforcement comes among others in the form of a transparent mrp study. Intention is to develop and apply the best possible solution for the mrp puzzle, which provides adequate vitality for the external and internal developments.
DTCF hopes hereby to set first step towards a transparent mrp solution in order to reinforce its competitive strength. The transparent solution to the mrp puzzle enables DTCF to shift the client focus on the cash flow estimation process (see sub-paragraph 1.3.3 and chapters 2, 3, 4 and 5).
With the mentioned aspects in mind, this chapter continues with the organisation introduction paragraph (1.3) and the research methodology paragraph (1.4).
§ 1.3 Deloitte & Touche Introduction
Deloitte & Touche (DT) is one of the Netherlands leading professional service
organizations, offering accountancy, tax, consulting and legal services. DT employs 7,500 employees at 90 offices across the country. Consultants at DT are specialized in
management consulting, corporate finance, actuarial benefits, information communication technology, human capital, and legal services. The organisation has more than ten
thousand clients in the Netherlands, from small and medium sized enterprises to large national and international companies. Their portfolio also includes a large number of government and not-for-profit institutions. At DT, selected industry sectors get individual attention.
In short, DT provides customised services, where points of departure are the clients’
individual requirements. DT is committed to a highly personal approach based on the extensive knowledge of current and potential clients and their clients. Internationally, DT is part of Deloitte Touche Tohmatsu (DTT), which is one of the global ‘Big Four’
accountancy and consulting organizations, employing 95,000 employees in 140 countries.
Mr. Piet Hoogendoorn is the World Chairman of DTT, whereas Mr. Jim Copeland is the
Chief Executive.
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§ 1.3.1 DTT in the Netherlands
In the Netherlands, DTT consist of five partnership associations functioning under Deloitte
& Touche (DT). The board of directors at DTT is in Rotterdam and has final organisational responsibility. Situated under the board of directors are discipline directors, staff directors, and market directors. The council board has an advisory role towards the DTT board of directors. Regional directors, situated under the board of directors, are grouped around three regions in the Netherlands. These are the Western, Northern and Southern region.
Another part of their responsibility centers are consultancy and legal services (see appendix 1a).
Different disciplines have their own organisational responsibilities. Throughout the years, different specialisations have directed towards special branches within DT. These
specialisations structure the DT consultancy group consisting of five subsidiary units.
These five subsidiary units are management solutions, financial advisory services, human capital group services, small business and entrepreneurship services, and government solutions (see appendix 1b).
§ 1.3.2 DTCF in the Netherlands
DTCF is part of the financial advisory services (FAS) group situated in Amsterdam. FAS provide services concerning corporate finance, transactions, reorganisations, real estate, financing, and grants. DTCF founded in 1986 as Touche Ross Financial Services Center B.V., originates from the Touche Ross-group. From 1991, DTCF operated under TRN Corporate Finance B.V., where in 1992 the final step towards DTCF B.V. followed. From historical perspective, DTCF has grown to a specialised company providing standardised solutions for a great variety of industries. With forty employees, DTCF is one of the
largest corporate finance organisations in the Netherlands. From international
perspective, DTCF is part of two internal corporate finance networks operational at DTT.
Primary goals of this global network are to establish a clear international company image and to offer clients solutions with an international dimension.
As mentioned earlier, DTCF provides corporate finance services for a great variety of industries organised around three service lines. The DTCF service lines are mergers and acquisitions, business valuations, and private equity together with structured finance. The mrp research is conducted within the business valuations service line. From the above- mentioned service lines, DTCF is organised around nine industry groups. These are consumer business, energy and utilities, transport and logistics, technology and telecom, manufacturing, media, business services, public sector, and financial services &
institutions (see appendix 1c). Five staff departments assist these industry groups. These are board administration, risk management, human resource management,
administration, and research (see DTCF organisation chart appendix 1d).
§ 1.4 Research Methodology
In this paragraph, a description of the research background together with the problem
definition, the conceptual framework and the phase framework will outline the scope of
Eldar Hasic 9 Deloitte & Touche Corporate Finance
this research. There are several methodology approaches for a problem definition. The mainstream business administration methodology provides the instruments for analysis, design, and control of organisations. Here the process behind the management and the decision-making activities that take place within and outside of organisations are the central departure point of the research.
§ 1.4.1 Research Background
The DTCF business valuation service line, primarily operating in the Netherlands, has to cope with several factors in their valuation analysis. The externally driven uncertainty and ambiguity originates from the mrp application deployed by the various financial institutions in the Netherlands. Here, a financial manager can observe various mrp values in the conducted valuation reports. Even more interesting is the underlying information behind the mrp value, which also differs across applied practice examples.
Different mrp values provide different present values in the net present value (npv) analysis. DTCF has observed competition among financial institutions, which have manifested itself in the practical valuation application in the Netherlands. The mrp values vary anywhere between 3% and 6% depending on the institution (see appendix 1e).
Additional values are provided in the end of appendix 4e.
DTCF consistently applies 6% mrp in their valuation reports, which roughly corresponds with the mrp values used by other competing accounting firms in the Netherlands.
However, the competition among the valuation institutions in the Netherlands has drifted away towards the mrp competition (see chapter 3). Depending on the position of the mediating party (sell or buy position) low and high mrp in the sell and buy processes could be used respectively. For example, if you are the selling party you might prefer a mediator who would provide you with the highest possible npv and therefore with the smallest mrp. On the other side, if you were the buying party you might prefer a mediator who would provide you with the lowest possible npv and with the highest mrp. A moral dilemma occurs here for many financial companies, where the fair trade policy is the only guide providing clear message towards competition and customers.
However, DTCF has observed various mrp applications. It seems that banks in the Netherlands use lower mrp’s, whereas the accounting and consulting firms are more conservative with higher mrp’s. According to the fair trade policy at DTCF identical mrp values must be used in the valuation analysis. Therefore, DTCF is in search for the transparent mrp, which suits best currently observed external developments (see chapter 2 and 3).
The corporate finance market in the Netherlands has undergone several drawbacks in recent years. In the Netherlands and world-wide confidence crises and volatile
economical developments were of mayor impact on the index developments. In the
Netherlands small corporate finance firms have become active in niche markets. On the
other side, DTCF is confronted with large banks and other consulting firms providing a
Eldar Hasic 10 Deloitte & Touche Corporate Finance
great variety of corporate finance services. In addition to the mentioned market players, DTCF have identified some universities and scientific platforms providing solutions for the mrp puzzle. Taken all together, clients are increasingly aware of these market shifts and are demanding and critical in the provided valuation analysis (see chapter 3 and 4).
From internal point of view, DTCF has merged with Andersen Corporate Finance in the Netherlands. Andersen as a global player has been split because of the legal claims in the U.S. in 2002. DTCF’s goal here is to establish clear guidelines towards competitive valuation practice, which reinforce and encourage trade positions and provide clear messages towards the competition. During the valuation meetings various ideas and practice examples are discussed in-depth.
DTCF is continuously working on the integrated approach towards adequate valuation analysis coping with the current and expected future market developments. By the means of its learning capacity DTCF hopes to make a step towards an integrated business valuation application. Learning process goes through different stages but the DTCF goal here is to stay on the path of the knowledge seeker in order to provide transparent solutions. Accordingly, DTCF intends here to further improve its current valuation practice.
The challenge is to held open discussions internally and externally. The openness is needed in order to encourage learning processes and to improve perceptions on individual and group level.
DTCF needs to remain a competitive valuation practice, where further discussions, interpretations and viewpoints will help explore and establish its competitive strength.
Here lies the challenge for DTCF, which is the interpretation of the data and being able to apply it to the current and future business developments.
This paper provides initial steps towards transparent answers to the mrp puzzle, which will address the challenge of the data interpretation and its application to the current and expected future business developments.
§ 1.4.2 Research Question and Preliminary Conceptual Framework
When defining a research question three elements are worth considering. These are the research question, the research goal, and the conditions [De Leeuw, 1996: 129].
However, there are many approaches towards defining a research question. The choice is not made arbitrarily but it is based on the subsequent application of the research
background elements. This thesis will start with a series of sub-research questions. These
sub-research questions are based on the literature research, where various relations are
assumed to exist that could be related with the transparent mrp.
Eldar Hasic 11 Deloitte & Touche Corporate Finance
Figure 1a is the preliminary conceptual framework, which offers a basic research structure of this thesis. Accordingly, the relationships established in this model will be briefly discussed and explained.
Figure 1a: Preliminary Conceptual Framework
In the financial literature it is often assumed that the external developments are related to the systematic risk development. The systematic risk development is related to the impact of movements in the macro economy. Recently, research has been published where six factors influencing the modern economies reduce risk. Moreover, it is argued that may also reduce risk.
In current financial methodology market efficiency is related to the systematic risk development. The manner in which the markets provide information and the reaction of investors to this information it is argued to be of influence on the required risk premiums.
Because there are various models that estimate the market risk premium, it is necessary to evaluate these models in order to indicate their relevance for the research purpose.
Moreover, many of these models create a puzzle, because they estimate high market risk premiums in situations where the investors market risk premiums is low and vice versa.
External factors:
1. Globalisation and growth;
2. Labour Mobility;
3. Market Sophistication;
4. Information &
Information Technology;
5. Agency Costs &
Concentration;
6. Government Regulation and Policy; and, 7. Business Cycles.
Market Efficiency The Market Risk
Premium Puzzle Explanation
Models of the Market Risk
Premium
Internal Factors at DTCF:
Strategic Choices, Formalisation, Standardisation, and Communication and Information.
Possible
Transparency
Eldar Hasic 12 Deloitte & Touche Corporate Finance
DTCF requires a transparent look on this subject. Therefore, a better understanding of market risk premium will be provided from the external perspective. However, from the internal point of view a transparent understanding of this subject must also be provided.
The internal analysis covers the interpretation, processing and application capability at DTCF. The DTCF strategic choices, formalisation, standardisation, and communication and information capabilities will be addressed here. DTCF desires here in order provide DTCF with a transparent mrp.
From many conversations and internal intervieuws with the DTCF-valuation experts the following set of research requirements can be formulated for the transparent mrp:
1. Objective: The assumptions and modelling decisions behind possible approaches must be systematically described.
2. Informative: The transparent mrp contains adequate qualitative and quantitative information and must be transparent.
3. Qualitative and quantitative information: The transparent mrp provides sufficient descriptive and qualitative interpretations.
4. Practically applicable: The transparent mrp must be easy in processing, interpretation, and application.
5. External developments: The transparent mrp must be related to the external developments in order to understand the problem infull.
6. Internal developments: The transparent mrp must be embedded into the DTCF internal organisation.
7. Establish transparent mrp: The transparent mrp should contain above-mentioned and analysed aspects.
Sub – research questions:
1. What external developments are of influence on the mrp and valuation practice at DTCF?
2. What internal organisational developments are of influence on the mrp and valuation practice at DTCF?
3. What mrp models are of relevance for the valuation analysis?
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4. How can externally, internally, and academically models can be integrated into a transparent mrp?
5. How does one receive the desired information for a transparent mrp?
6. What is the learning effect of the transparent mrp for DTCF and in general?
§ 1.4.3 Research Overview
In chapter 2 external developments and their relationship with the valuation and mrp general practice will be described. From an aggregate point of view an introduction of the systematic risk development is provided. Accordingly, the basic insight of the business cycle development in the Netherlands and its relationship with the transparent mrp is presented. Additional remarks will address relevant benchmarks for the DTCF internal organisation.
Because this chapter provides more general introduction it would be impossible to provide direct specific information about the clients and competitors. Chapter 2 provides general implications for DTCF when the client perspective is considered, because clients are bounded by the business cycles development. Here the relationship with the targeted industry sectors is provided (see paragraph 2.2).
In chapter 3 practical views of the applied valuation approaches at DTCF will be given to assist in the analysis of the internal developments. It is an analysis concerning the manner in which the DTCF uses the mrp and other related valuation instruments.
Additional remarks will address relationship with the external environment, where the client and competition aspects are of importance.
In chapter 4 a literature overview provides insight into the valuation instruments, the mrp and the alternative valuation methodology instruments. Categorisation of the analysed theories and models will be provided. Special attention is provided to the competition aspects where their studies are analysed.
In chapter 5 the transparent mrp and its implications for DTCF will follow, where remarks concerning practical applicability will be placed. Here, previously described chapters provide input. The effects of the developed transparent mrp will be provided, where the manner in which it provides the desired information is of importance.
In chapter 6 a perspective of the general transparent mrp application will be provided. The insight into the relationship between DTCF interpretation capability, general
developments and the mrp puzzle is central.
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Chapter 5:
Qualitative and quantitative
valuation information for the long-
term valuation Chapter 5:
DTCF valuation
solution for the long-term
valuation analysis Chapter 2:
External analysis concerning
valuation solution Chapter 3:
Internal analysis concerning
valuation solution
Chapter 5:
Design of the DTCF valuation solution
system Diagnose
Phase
Design Phase
Chapter 4:
Literature study concerning
valuation solution
Chapter 6:
Conclusions and Learning
Loop
Figure 1b provides the two stages of this research. The two stages are visualised in terms of a flow model in order to understand the processes behind the research. The research phases are the diagnose- and design-phase.
Figure 1b: Research Sequence
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Chapter 2 External Analysis DTCF
In chapter 2 an answer to the first question will be provided: “What external developments are of influence on the mrp and valuation practice at DTCF?”.
Chapter 2 provides insight in to the environmental shifts and their relationship with the business valuation practice and the mrp application in general and at DTCF. Exploration of the external developments provides the first step to the transparent data interpretation application in the current and future expected business development.
In paragraph 2.1 theoretical concepts behind the environmental shifts are introduced. The shifts caused by the environmental variables and their relationship with the risk
development are reflected in the business cycles in the Netherlands and world-wide.
In paragraph 2.2 a business cycles introduction and an overview of currently observable environmental pressures with expected changes caused by the environmental shifts will be provided. These factors force many financial companies to adjust and change current business policy.
In paragraph 2.3 an overview of external conclusions for DTCF is provided, where the relationship with the transparent mrp is provided.
§ 2.1 Environmental Shifts
Many authors provide insight into the environmental shifts and business cycle developments. The purpose of this paragraph is to analyse relevant aspects of the environment influencing the business cycles and mrp development in the Netherlands.
Weber [1997: 65, 67, 68 and 71] studied and identified at least six factors behind the environmental shifts dampening the business cycle development. The six factors of the modern economy are globalisation and growth, labour mobility, market sophistication, information and information technology, agency costs, and government regulation and policy.
The following paragraphs will extrapolate the underlying factors behind the environmental
shifts in both countries. Here other authors will broaden up six facets of the modern
economy in order to provide a coherent and a consistent argumentation related to
business cycles or other structural factors and transparent mrp.
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§ 2.1.1 Globalisation and Growth
The question whether we are globalising or not is fundamental in this paragraph. It is impossible to describe all pros and cons of the globalisation processes. The description of globalisation and growth prospects and their underlying arguments will be based on various authors proving arguments for the research goal.
Brakman, Leeflang and Sterken [2000: 24, 25 and 26] provide an overview of the
changing global economical structures together with the demographical and technological developments.
1Internationalisation is possible because each country concentrates on its relative competitive advantage and thereby provides other international partners trade margins.
2It seems a common fact that in the previous decennium globalisation has grown enormously into various manners. The assumption underlying the mentioned statement is misleading. The world trade as a percentage of the world domestic product, before the First World War in 1913, was roughly 12%. Volatile developments, wars and crises in the thirties have caused global trade to fall. In 2000 global trade was 20%, which is
comparable to the economy openness of 85 years ago. The growth of the global trade is comparable to those of individual industrialised countries (see appendix 2a).
According to Brakman, Leeflang and Sterken [2000: 25, 26 and 28] the export capability of the newly industrialised countries, from the perspective of the industrialised countries, has no significant impact on trade development. The amount of export from these
countries is roughly 2% in 2000. The internationally established patters are very stable, where large world blocks establish trade internally. From 1860 Europe has internal trade development, where only competition is from the countries with similar economic growth (mostly European countries). A surplus of capital streams from the OECD-countries is roughly stable from 1870, which is indicating the net capital stream among them. The amounts and the effects of the globalisation and growth in the form of international trade and capital streams should therefore be nuanced. However, changing trade barriers and competition confront the current economies with a new phenomenon, the globalising world economy.
A more optimistic picture emerges in the research conducted by Petit, Gulic and Park, which is based on the Weber study. Pettit, Gulic, and Park [2001: 2] argue that the worldwide market capitalization has tripled in the past ten years creating larger markets.
Larger markets afford therefore more liquidity, less volatility, and hence less risk. Whether in toys, textiles, automobiles or commodities, the global sourcing and production have
1 A study closely related with the Webers paper, where similar facets of modern economy are used and explained. The focus is on the manner in which the markets in Netherlands will function and further develop. Accordingly, the consequences of these developments for the companies in the Netherlands are discussed. Especially their ability to comprehend the information flow and deal with
information uncertainty is addressed. According to them, the short term developments on the financial markets are best to predicted by the random walk theorem, where the best estimate for tomorrow is based on today’s expectations (see chapter 4). When the long-term developments are considered the error on the probability chance of event occurrences will rise with the square root of the long-term time horizon.
2 M. E. Porter [1990: 72] provides the Porter Diamond reflecting the competitive superiority of countries. Four conditions are important for the competitive superiority: demand, factor endowment, related and supporting industries, and firm strategy, structure and rivalry.
Eldar Hasic 17 Deloitte & Touche Corporate Finance
increasingly become evident. The growth of emerging markets (typically double of those for the developed world) often serves to buffer the down cycles of developed economies.
The emerging markets development helps developed economies to invest further in human and technical capital. However, the developed markets often, in turn, buttress the volatility on the emerging market. Although claims of a borderless global economy are vastly overstated, there is a reduced sensitivity in the world economy to the economics of any single nation, which reduces systematic risk in the world economy.
According to Ruigrok and van Tulder [1995: 1141 and 1144] it does not matter whether a researcher looks at the macro-economical developments or company strategies it is still difficult to access empirical measurement of the globalisation processes. Here the globalisation debate is mainly provided from the American and Japanese perspective.
This explains confusing debates and different perspectives on the subject in the Netherlands. In Europe globalisation discussion has emerged in late eighties from the reactive regional perspective. The dominant trend in Europe was not globalisation but regionalisation especially for the European companies.
From one perspective markets are becoming larger, more liquid, etc.. On the other hand evidence suggests that the markets have hardly changed since the beginning of the last century. In the past two decennia globalisation and growth has become an evident factor.
It is argued that the prospect of globalisation and growth has provided a cushion for the systematic risk occurrence and therefore has lowered required risk premiums (the mrp).
However, the amount of systematic risk reduction contributable to the process of
globalisation is difficult to assess. This is caused by difficult empirical measurement of the globalisation process as well as by the various ways in which the market risk premium is measured (see chapter 4).
§ 2.1.2 Labour Mobility
The internationalisation process importance is explained in terms of relative competitive advantages and trade margins among countries. Currently industrialised world is
concerned with the competitive strength of the low-wage countries, which produce
cheaply and provide competitive low prices. This causes problems in low-labour segment of the industrialised countries (European countries and the U.S). The free trade
establishment, providing consumers low-prices, provides the offset. The corporate
productivity in the Netherlands in the industry sector is growing harder than in the service sector. Therefore, trade conditions are of mayor impact on the labour development in the low-wage segments in the Netherlands [Brakman, Leeflang and Sterken, 2000: 27].
3Because of the growing competition of the Eastern European countries this notion is increasingly important for the Netherlands [Ruigrok and van Tulder, 1995: 1144].
3 Ruigrok and van Tulder [1995: 1144] provide examples of Dutch companies outsourcing their low-wage activities. Realised cost savings from the production outsourcing is offset by the transportation costs, the search for the highly skilled labour, the consumer preferences, and trade barriers.
Eldar Hasic 18 Deloitte & Touche Corporate Finance
The service economy development is related with the third industrial revolution caused by information and communication technology. The ratios behind the gross domestic product (see appendix 2a) are comparable in 1913 and 2000, but the underlying factors driving the overall corporate productivity have changed significantly. In the seventies an
important part of the gross domestic product is attributable to the international trade and the information and information technology. However, service sectors are still bounded by location and are hardly tradable. A mayor part of the production in the service and
industry countries is in form of services [Brakman, Leeflang and Sterken, 2000: 27].
The development of markets is based on the Anglo-Saxon (markets as coordinating mechanism) and Rijnlands (institutions as coordinating mechanism) perspective. In Europe there is a slight trend towards the Anglo-Saxon perspective, where labour and product markets will be deregulated to improve competition. Here individual agents are actively seeking for the fine-tuned high return – risk combination. The risk reduction is accompanied with the shifts in the demand and supply curve of flexible labour,
specialised goods, and risky assets. The latter two aspects will be extrapolated in the following sub-paragraphs. For example, the Central Bureau of Statistics (CBS) in the Netherlands has shown a trend from 1994 where employee’s trade-off is the high salary and less fixed contracts [Brakman, Leeflang and Sterken, 2000: 27 and 33].
However, effects have also been caused by the growing economy of the nineties. The modern economy, as Jacobs [2000: 44 and 47] argues, is caused by the long-term economical trend, which is caused by new technologies. The evolution in the knowledge economy is evident and crucial for countries to evolve towards enhanced knowledge integration in order to become competitive. This is in particular the case in times of high economical developments. It remains to be seen of these developments can withhold current economical and government policy developments in the Netherlands.
According to Weber [1997: 71], the U.S. shifts in employment – from manufacturing to service jobs and from career employment to temporary employment contributing to the business cycle dampening. In the fifties, the service industry has employed about half of the U.S. workers. In the mid-nineties services industry accounted for almost 80% percent of the American jobs. The U.S. numbers are the most dramatic, but they are not out of line with the trends in other advanced countries. Brakman, Leeflang and Sterken [2000:
27] confirm this by addressing developments in the low-wage segments of the industrialised countries caused by productivity increase. Weber [1997: 71] suggests thereby that labour developments result in less cyclical service employment than in the manufacturing industry.
Pettit, Gulic, and Park [2001: 2] provide evidence where service and manufacturing cycles
can be offsetting. Here the service economy has less fixed cost and is less susceptible to
pricing pressures in times of overcapacity. Weber [1997: 71] argues that this development
is caused by the diminishing power of labour unions, because the labour unions are
typically stronger in manufacturing industry. However, trend towards marketable and
mobile knowledge workers helps to reduce fixed costs and increase resource allocation
within the economy [Pettit, Gulic, and Park, 2001: 2]. Declining union power contributes to
the development of increasingly flexible labour markets, extending to downwardly flexible
real wages in some OECD-countries. Labour market flexibility gains from the shift of the
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old paradigm (lifetime employment) to a new paradigm (temporary work causing labour flexibility) that is expanding rapidly [Weber 1997: 72].
The effects of flexibility in labour developments in the Netherlands could in theory contribute to the systematic risk reduction and lower required risk premiums because it assists in generating a less volatile and more predictable economical development. The amount of the systematic risk reduction attributable to the flexible labour markets is unfortunately unknown.
§ 2.1.3 Market Sophistication
The neoclassical theory of economy assumes that each economical system is made of fully integrated markets reflecting all available information reflected in prices as described by Arrow and Debreu [1954 (see reference below)]. In reality such system is nonexistent, because of the influences coming from different institutions and bounded rationality. Two perspectives on markets are provided in the previous sub-paragraphs. The successes of the U.S. economy in the past decade were influential on the European countries. The question is whether ‘more’ markets can lead to the higher growth. When financial markets are considered this seems to be case. The European financial markets are growing towards the Anglo-Saxon perspective [Brakman, Leeflang and Sterken, 2000: 29 and 30].
4The increased volatility caused by the deregulation effects leads to the greater risks for the individuals demanding improved risk measurement. For that reason an increased need emerges for quality guarantees concerning the financial products and services. At the same time a growing need for the insurance products will emerge because of
increased volatility. The risk management will become an important part of the
organisational setting. An example is found in the rapid emergence of financial products (like derivates). Alongside with the currently traded products, additional products are needed to fulfil the increasing market need [Brakman, Leeflang and Sterken, 2000: 34].
These developments are currently observable in the Netherlands especially in recession periods. The increasing need for financial securities increases with higher volatility.
Pettit, Gulic, and Park [2001: 2] provide similar representations. The proliferation of risk management products (derivatives) has increased the liquidity of risk, allowing it to be isolated, traded, syndicated and more actively managed. Most individuals invest in the markets through funds and institutions leading to an increased sophistication and fundamental change in the nature of the equity markets.
Weber [1997: 72 and 75] argues that despite of few heavily publicised losses on derivate contracts, the amount of new financial instruments will increase. Corporate treasurers and
4 According to these authors, the larger markets are becoming, the better background will emerge for innovation. Two visions are of importance: Schumpeter (concentration on the production processes leads towards innovation) and Porter (competition leads towards innovation). The capitalistic market economy needs both perspectives creating the good conditions for innovation.
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fund managers will become steadily better at using these new tools to stabilise financial flows and protect themselves from financial shocks. Accordingly, global financial markets will become more and more efficient at linking capital to production, managing risk, and providing shock absorbers that cushion economic fluctuations. The emergent market growth and the organisations’ ability to cover risk should dampen the business cycles.
The increasing effects of deregulation could cause the markets to become more efficient and therefore reduce the systematic risk and required risk premiums. Risk management is one of the recent developments, which is becoming more evident in many
organisational settings too. As theoretically argued, these risk management developments have lowered required risk premiums.
§ 2.1.4 Information & Information Technology
Schumpeterian business cycles can be found in the perceived economical developments, where the coal technology was replaced by the oil and oil with the information and
information technology. Every shift brings volatile developments for the technology and economical infrastructure [Hart and Milstein, 2000: 8].
Increasing transparency and efficiency reflects advantages of the markets as coordinating mechanisms. However, a greater role of the markets creates volatile shifts because of the deregulation effects. The growing influence of the information and information technology reduces processing and interpretation time of the potential financial price differences (on financial markets), which in turn reduce and limit volatility. In the Netherlands the
technological development is pushed by the economical growth, which is the primary motor of the consistent long-term growth development. Technological developments create different data collection and interpretation manners that are propelled by various communication possibilities. The production process and innovation development is highly determined by these developments [Brakman, Leeflang and Sterken, 2000: 28 and 30].
Organisations are increasingly taking decisions based on enhanced qualitative and quantitative data processed by the information systems. Consequently, the larger the financial markets are becoming, the greater the chance for potential financial mistakes creating increased volatility in prices. The rising role of information and information
technology as an instrument towards transparent and efficient markets is here to be found [Brakman, Leeflang and Sterken, 2000: 29 and 34]. On the other side of this perspective, Jacobs [2000: 47] argues that the information technology has produced new products and services but the technological and economical wastage has become a significant factor.
Pettit, Gulic, and Park [2001: 2] argue that the new technology will create immediate and
comprehensive disclosure, reducing uncertainty and thus required returns. The coverage
of various regulations, segment data, reporting requirements, and analyst forecasts are all
more extensive and of higher quality today than in the previous decennia. Information
technology has reduced the price and raised the quality of information processing. Weber
[1997: 72] provides arguments where on an abstract level information technology reduces
the price and raises the quality of the information companies use for decision-making.
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Arnott and Ryan [2001: 4] provide cons to the advocates of the new industrial revolution.
A casual economy observer would agree that the technology revolution is real. On the other hand its impact on the future gross domestic product development estimate remains to be seen. Their argument is that the technology revolution is of modest impact. As humans, we still need to eat food, drive cars, live in homes, and buy toothpaste and soap.
Bits and bytes cannot replace traditional goods and services no matter how much the information revolutionises flows and communications. The new technology can only materially reduce the costs of production and delivery of goods and services. However, current technology developments can increasingly redefine the world of information flows and communications by providing enhanced productivity and thereby create more rapid gross domestic product growth than observed in the past.
The rising role of information and information technology creates better conditions for market efficiency and transparency. The technology revolution can prevent the potential financial mistakes and therefore result in less volatility in prices. These conditions could then theoretically create comprehensive disclosure and thereby prevent systematic risk to rise. The outcome of these developments could increase trust of the investor community and also enhance a less volatile economy development.
§ 2.1.5 Agency Costs & Concentration
In the Netherlands products and services sector concentrations will increase backed by steadily growing horizontal integration by the means of joint ventures, strategic alliances, mergers and acquisitions. The Euro introduction has additionally reinforced this
development by economies of scale and scope. There are many advantages and disadvantages followed by the concentration effects. An advantage is that the large stockholders can easily observe movements of various companies. A disadvantage is the abuse of market power leading towards less competition. The government rules and regulations are adjusted and are still adjusting to enhance fair competition in order to prevent monopoly situations [Brakman, Leeflang and Sterken, 2000: 32]. Enhanced
market conditions can regain the trust of the investment community by taking measures to prevent disadvantages of the concentration effect.
The deregulation effects are accompanied with greater instability that is causing systematic risk to rise and thereby creating a mounting need for better control of the financial institutions and intermediary parties. The increasing risk and volatility
development create a demand for the quality-marks and guaranties. The general idea is straightforward. An environment with great profit opportunities increases chance for the corruption development, which is a primary breeding ground for instability as observed in the recent years [Brakman, Leeflang and Sterken, 2000: 31].
5According to Noteboom [1997: 947] trust is a cheap instrument in order to reduce risk. However, trust cannot be purchased or installed because it needs time to develop. An important trade-off here is between continuity and flexibility.
5 Agency costs are incurred when (1) managers do not attempt to maximise firm value and (2) shareholders incur costs to monitor the managers and influence their actions [Brealey and Myers, 2000: 8]
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Along side with earlier mentioned findings concerning concentration effects, a mergers and acquisitions paradox emerges. The growing competition pushes largest European and American companies into a prisoner-dilemma when the mergers and acquisitions effects are considered from purely economical backgrounds. The growth of the industrial concentration is for three quarters attributed to the external growth. Strong evidence exists that mergers and acquisitions do not contribute to the income and market growth.
Accordingly, mergers and acquisitions do not contribute to the companies economic improvement despite of the multi-milliard spending. Here exits a positive correlation between the manager’s income and reputation and company size. The managers’
preferences could be leaning to the company growth instead of the profit growth. As a result of these developments managers could take decisions against their will [Schenk, 1996: 248 and 149].
Pettit, Gulic, and Park [2001: 2] have more optimistic view on the subject. The success of leverage buyouts and the widespread adoption of economic value added (EVA®) provide large investors more active and influential positions in companies. The improved position of the large investors forces many companies to maximise shareholder value, which also reduces the risk of common stock.
Agency instruments are not always adequate enough in order to prevent undesired actions and this may generate loss of trust in the investment community. However, the effects of improved control resulting from reduced agency costs and ownership
concentration is related to trust.
6These developments could then theoretically be accompanied with less volatile developments and systematic risk reduction.
§ 2.1.6 Government Regulation and Policy
The deregulation process of the government rules and regulations will primarily determine the outcome of the cluster process. When the market coordination prevails over some government policies a strong volatility increase can be observed causing the systematic risk to rise. The Netherlands cluster policy is focused on quality improvement of the overall production package, which is primarily driven by innovation. The government’s goal here is to create excellent entrepreneurial conditions for dynamic market processes and thereby to prevent cartels. The government could take here the role of the stimulator, agent and market party [Wijers, Roelandt, and Volman, 1997: 943 and 944].
However, the Netherlands government policy varies from time to time and is largely dependent on the European laws and regulations. The law and regulation role of the European Union determines a great variety of the volatility driving factors. Companies can pursue here profitability, because different governmental actions at home and abroad
6 Principal – agent problems would be easier to resolve if everyone had the same information. That is rarely the case in finance.
Managers, shareholders, and lenders may all have different information about the value of a real or financial assets, and it may be many years before all the information is revealed. Financial managers need to recognise these information asymmetries and find ways to reassure investors that there are no nasty surprises on the way [Brealey and Myers, 2000: 9]. In the recent years various nasty suspires could be observed in the Netherlands and the U.S (Ahold and Enron respectively).
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influence profitability development by the manner in which the taxation, earnings and prices are regulated [Daniels and Radebaugh, 1995: 17].
In the end of the twentieth century, the collective amount of money spend by the Netherlands government is roughly half of its national income. The large government spending, extensive tax regimes and governments regulations imply widespread influence of the Netherlands government influencing society and economics. The government is hereby an excellence instrument to prevent recessions and encourage economical growth. On the other hand poor government policy can enhance crises and recessions [Koopmans and Wellink, 1999: 188 and 189].
The manner in which the global accounting standards will develop provides a good example. An international financial reporting standard (IFRS) is the new name for
pronouncements of the international accounting standards board (IASB). The movement toward IFRS as the worldwide accounting benchmark affects the environment in which all companies operate. All 7,000 publicly listed companies domiciled within the European Union are required by law to prepare their consolidated financial statements in
accordance with IFRS by 2005 [Pacter, 2003: 1].
7Pettit, Gulic, and Park [2001: 2] provide arguments from the U.S. perspective. An international political economy with the subdued business cycles in the industrial core operates differently than earlier political economies. The liberalization process of
developing economies, establishment of trading blocks, and opening of international trade have contributed to the global economic growth, despite tremendous political change and upheaval. The prudent monetary policies of the Federal Reserve and its foreign
counterparts, as well as the general liberalization of regulatory policies, have also reduced the volatility of business cycles.
A poor government policy and the strong emergence of the market coordination are reflected in the increased volatility, which could cause the systematic risk to rise.
However, the careful monetary policies create better investment conditions and therefore reduce the volatility in the world-economies. The amount and the possibilities of the risk reduction here are unclear, so these relationships can elsewhere be further discussed and analysed.
7 This requirement will affect the subsidiaries, associates, and joint ventures of 7,000 entities, many of which are located in the U.S.
The listed companies in ten proposed countries for the European Union expansion by May 2004 must adopt IFRS in 2005. Some European countries will permit or require IFRS for non-listed companies, of which there are 5 million. Proposals to require IFRS have been made by Australia and New Zealand. These new adopters, by 2005 IFRS will be required for reporting by some or all-domestic listed companies in at least 60 countries, and permitted in another 21. A larger number of countries will allow IFRS for foreign issuers.
In the U.S., a foreign company registered with the Security Exchange Comity (SEC) may submit IFRS or local General Accepted Accounting Principles (GAAP) financial statements, but a reconciliation of earnings and net assets to the U.S. GAAP figures is required. In effect, companies are forced to keep two sets of books. In February 2000, the SEC issued a Concept Release, International Accounting Standards (IAS), inviting views on whether and how IAS might be permitted for foreign registrants, and possibly domestic registrants. These matters continue to be under study [Pacter, 2003: 1].
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§ 2.2 Business Cycles and Economical Outlook
In this paragraph the business cycle expectation and general economical developments in the Netherlands are briefly provided.
§ 2.2.1 Business Cycle Expectation
The definition of a business cycle differs across studies. According to Weber [1997: 65, 67, 68 and 71] a typical business cycle has four stages: prosperity, transition, depression or recession, and recovery.
8No one is precisely sure why business cycles occur. Modern business-cycle theory is essentially a series of stories about cyclical developments to crises. The real questions are where do cycles come from and what drives a business cycle.
Two lines of arguments see cycles rising primarily from the demand side. The first line of arguments are the errors in the monetary policy causing errors in the real expectations.
The second line of arguments are the assumptions made by companies about
consumption and production.
9All these decisions and assumption have to be made in the context of mixed and confusing data as well as volatile and uncertain expectations about demand, technology, productivity, future prices, and so on. These expectations are
erratic. Irrational exuberance can then cause too much spending, while pessimism can do the opposite [Weber, 1997: 68].
Cycles can also come from the supply side. An embargo, a war, or even a fluctuation in weather could dramatically change the price of important inputs. Productivity shocks, usually brought on by a sudden change in technology altering the cost of production or resulting in entirely new products can upset the basic contours of supply. New
technologies require decisions about new capital goods and these decisions take time. In the interim, innovations cause price fluctuations that set off business cycles. Uncertainty in business planning leads to mistakes that are spread throughout the economy. This uncertainty is made worse by the competitive structure of the economy and the time lag between perceived demand and production [Weber, 1997: 68].
Complex psychological factors come into play as business planners look to the external world, with its confused signals about prices and demand, and to each other for signals of optimism and pessimism. Business investments fluctuate while inventories and contracts expand in ways that does not closely reflect changes in demand. Prices may shift
8 An important theory of innovation and diffusion is derived from the economist Schumpeter, where he defined three stages: invention, innovation and diffusion [Nooteboom, 2000: 119]. Schumpeterian industry life cycles are used by increasing number of scholars to describe essential regularities in industrial development [Gemser, Leenders and Wijnberg, 1996: 441]. Here Gemser, Leenders and Wijnberg [1996: 442] have used the De Jong classification, where four phases of the industry life cycle are distinguished: emergence, growth, maturity and decline or de-maturity. Here are various manners provided on how to approach business cycles.
9 J. M. Keynes provides arguments for the second scenario. Keynes claimed that private decisions to consume depend on an individual psychology and the relationship between his or her income and spending [Weber, 1997: 68].
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relatively easily to adjust for new market conditions, but wages, which are sticky, generally shift less, causing unemployment. All these factors multiply and accelerate throughout the economy. Profits fluctuate and so the future expectations of profits.
Investment calculation changes and so on and so forth [Weber, 1997: 69].
Pettit, Gulic, and Park [2001: 2 and 3] have used six facets of the modern economy to support the notion that the earlier history may be less relevant for the ex post derivation of expected equity returns. In addition to the qualitative arguments they have provided
empirical measurement and documentation for these structural changes. Some of the mentioned forces have led them to rely principally on the past five decades for the mrp estimation, rather than the more conventional seventy-five-year view. Here the U.S. could be the best proxy for the ex post derivation of expected equity returns (see chapter 4).
The central theme behind this sub-paragraph is the manner in which the risk spreading can be achieved. A conclusion is that the business cycles vary among countries.
10However, the impact on the amount of the systematic risk and risk premium is unclear.
§ 2.2.2 Environmental Outlook
In this sub-paragraph general economical developments in the Netherlands are briefly provided. All subjects are related with the first step of the defined research objective. In the Netherlands CPB is the Bureau for Economic Policy Analysis. In March 2003 the most recent expectation for the economic growth is published [CPB, 2003]. Several aspects of the economic growth are provided. The provided analysis is based on the industry groups targeted by DFTC (see appendix 1c).
Economic: From the second half of this year, the Dutch economy is expected to grow moderately. The gross domestic product will probably increase by 0.75% in 2003 and for the next year a growth of 1.75% is projected. Provided outcome is likely to remain below the euro area average (1.25% in 2003 and 2.75% in 2004), due to a steady loss of the export market share in the Netherlands as a result of the increasing labour cost.
Labour: Unemployment is likely to rise steeply, from 3.9% of the labour force in 2002 to 6.25% in 2004. Uncertainties about the economic developments on the short term are mainly caused by international tensions.
Risk: In the central projection, it is assumed that international tensions will ease in the first half of this year. In 2004, the economy is likely to recover somewhat and the gross domestic product will grow by about as much as in the central projection, though not making good for the loss incurred in 2003.
10 As earlier debated by Daniels and Radebaugh [1996: 17] (see previous sub-paragraphs for details).
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World Trade: The average gross domestic product growth in the industrial countries is expected to pick up from 1.5% in 2002 to 2% in 2003 and 3% in the next year. World trade growth will probably accelerate from 3.1% in 2002 to 7% and 9.5% in 2003 and 2004 respectively. The export market growth relevant for exporters in the Netherlands will accelerate less, from 1.9% in 2002 to 5.25 this year and 7.75% next year. The U.S. is likely to lead the economic rebound. The real gross domestic product growth in the U.S. is projected at 2.75% this year, accelerating to 3.75% in 2004. Accommodating monetary policy and fiscal stimulus will support economic growth. The drop in share prices will dampen it.
Investments: Investment activity is tempered by the cyclical downturn, a relatively low capacity utilisation rate, and a pessimistic view on economic growth by entrepreneurs.
Accordingly, the income from international investments has fallen. Solvency ratios are relatively low, so that businesses experience some difficulties in financing investments from their own resources. The cyclical growth of the labour productivity will attribute to the increase of the next year corporate profitability in the Netherlands. Non-residential
investments in the commercial sector are expected to increase by 1% in 2004.
Inflation and wages: In 2003 the consumer price index is likely to increase by 2.25%.
The developments in labour costs, import prices and indirect taxes, which led to a high inflation rate in recent years, reduce inflation this year and, especially, next year, with inflation in 2004 projected at only 1%. If the euro appreciates any further, this figure may even come out at a lower level. On the other hand, an upward risk lies with oil prices that could temporarily shoot up much higher.
Sectoral developments: The last year’s stagnation in world trade especially struck manufacturing. A moderate recovery of production growth in the commercial sector is foreseen of up to 0.25% in 2003. Within the commercial sector energy, construction, and commercial services show above-average growth. For 2004, a further recovery of
production growth in almost all parts of the commercial sector is likely. The ICT sector is expected to recover but growth will not be as in the second half of the nineties. The
commercial services sector is expected to increase moderately by 0.5% in 2003, and next year's growth will be more substantial, 2.5%. In the telecommunications sector, continued sgrowth for this year and the next is projected, mainly due to the expected growth of traffic in data communications both to fixed and mobile connections.
§ 2.3 Conclusion (confidential)
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